An Introduction to Bonds
Cash and shares appear to be the only 2 asset classes I seem to hear about in my travels and discussions with investors of all persuasions. There are actually 5 asset classes:
- Cash – liquid and powerful to buy anything immediately.
- Equity – owning part of a business (aka– Shares!)
- Fixed Income – lending money (and getting it back)
- Real Estate – owning a physical space, and
- Commodities – gold, wheat, oil, lithium etc.
I understand why commodities are not widely discussed; gold, silver, lithium and the like all have vibrant active markets attached to them. But they are mostly difficult to understand and require expertise well beyond the average investor.
The uninformed who venture into commodities usually get burned and there is many a “war story” attached to speculative purchases of diamonds, precious gems or metals that end in tears.
And while we are a real estate crazed country, transactions are not regular and usually require much larger sums to participate.
Bonds & Low Interest Rates
The world of low interest rates is now baked into first world economies, yet I’m still amazed many investors equate bond investing as low yield and very boring.
The chase for yield is more important than ever as a bevy of investors (many including retirees trying to eke out a living on their cash savings) are wondering where to place their money.
What are Bonds?
Put simply, a bond is a loan.
If you have ever borrowed money from a bank for a home, a car, a small business, that loan is a “bond”. Bonds engender key principles that have been in place ever since money was invented and lenders worked out a way to make a profit by loaning funds.
So, let’s talk about terminology, because in many cases that’s what makes bonds difficult to understand!
Jargon, industry speak and terms we are not familiar with is used by the finance industry to dress up and complicate what is simply – a loan.
Understanding the Jargon!
When we borrow money from the bank, we usually understand:
- How much we’re borrowing; (principal)
- How long we’re borrowing for; (term)
- The interest we’re paying; (coupon rate)
- Any security or collateral the loan is set against; (mortgage on a house, lien on a car or unsecured)
- Terms & conditions of the loan
Tables are Turned
When investing in bonds, you need to position yourself on the other side of the transaction.
You are now providing your money to someone else like a company, investment trust or similar. What terms and conditions are you happy for someone else to have your cash, and when do you want the cash returned.
Types of Bonds
Government / Treasury – as the name implies, they are issued by countries in their fiat currency or major currencies like USD, Swiss Francs, Euro, Yen etc.
Municipal / Corporate – issued by companies or lower government agencies looking for funds outside of their usual equity raising to fund expansions, stockholder buy outs or any other use.
Investment Grade – issued by investment vehicles like trusts, funds, broking houses that have been rated by reputable agencies like Moodys or Standard & Poor. Because they are rated doesn’t necessarily make them less risky, they simply have been reviewed by a “third party” agency.
Mortgage backed – issued by investment trusts and funds that use real estate assets (usually) to secure loans in case of default by the borrowers.
Others – any kind of loan that fits the criteria of providing credit, but without any regulation, government rules or protection and might include schemes to fund projects that don’t necessarily meet usual “standard” terms and conditions – aka “the Wild West”.
Six Key Factors When Investing in Bonds
As a professional fund manager dealing in asset backed investment bonds, we use a tried and tested methodology when choosing where to place our investors’ funds.
Simplify this – what if you were loaning money to a member of your family? I’ve devised my “Six Key Factors of Bonds” which will be further explained in my next Livewire article.
- Reputation. Do they have a solid track record?
- Maturity. When do you need your money back
- Return v Risk. Is it realistic?
- Collateral. Is it real?
- Plan B. What if things change?
- Tradeable. Are the bonds tradeable?
Investing in Bonds
I can’t stress this enough – investing in Bonds can be as risky or as safe as you
Equating a bond to an everyday loan you’ve previously experienced will hopefully make it easier to understand.
It really isn’t rocket science, you lend money out, and you make sure it comes back in.
And like any other investment if you don’t understand it – don’t invest!!
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Ray Trevisan is a Fund Manager and Director of OTG Capital, a boutique wholesale investment fund specialising in asset backed securities. He has over 40 years of business and investing experience.